Index Tracking with Utility Enhanced Weighting

Abstract

Passive index investing involves the low cost strategy of investing in a fund that replicates or, more often, tracks a market index. Enhanced indexation uses the returns of an index as a reference point and aims at outperforming this index. The intuition behind enhanced indexing is that market inefficiencies can be exploited to yield better returns. In this paper we propose a novel technique based on the concept of cumulative utility area ratios and the Analytic Hierarchy Process to construct enhanced indices from the Dow Jones Industrial Index and the Standard and Poor 500. Four main conclusions are forthcoming. First, the technique, called the utility enhanced tracking technique (UETT), is computationally parsimonious and applicable for all return distributions. Second, if desired, cardinality constraints are simple and computationally parsimonious. Third, the technique requires only infrequent rebalancing, monthly at the most. Finally, the UETT portfolios generate consistently higher out-of-sample, after-cost returns for the fully enhanced portfolios as well as for the enhanced portfolios adjusted for cardinality constraints.